The Cash Flow Statement

What information does a cash flow statement provide? Using a self-created example, explain the direct and indirect methods for calculating cash flows from operating activities.

The cash flow statement that a business produces "reveals the movement of cash over a period of and the effect of these movements on the cash position of a business" (Atrill & McLaney, 2006). This third mandatory financial statement is required because of the vital importance that cash has to a business. The cash flow statement summarises the receipt and payment of cash (and cash equivalents such as deposits held in a bank account which are easily accessible) over a period, and displays the net increase or decrease of cash in the business.

The cash flow statement will contain four main sections. The first shows cash flow from operating activities. It is the cash received from sales and trade receivables minus the cash paid to purchase stock, pay the workforce and other such activities. This section is calculated after tax and financing costs have been taken into account. The next section shows cash flow from investing - cash received from payment for non - current assets minus cash paid for non - current assets. The third section shows cash flow from financing - long term borrowings and share - related activities are examples of this. Finally, the fourth section will show the net increase or decrease in cash.

While the direct method of preparing a cash flow relies on combining all cash - related transactions for a particular category of operating activity, the indirect method uses the income statement as its starting point and works out the cash flow of the business from that (this appears to be much less work than crunching all the numbers for the direct method). "Most of the items in an income statement are related to operating activities as defined by the cash flow statement rules. Therefore, it is possible to reconcile the net income from the income statement to the cash from operating activities" (Trent, 2007).

A direct cash flow statement would look similar to the following:

Cash Flow Statement for month ended December 31, 2007

Operating Activities (£)
Cash collected from customers 50,000
Cash paid for rent (2,000)
Cash paid in wages (5,000)
Cash paid for utilities (1,000)
CASH FLOW FROM OPERATING ACTIVITIES 42,000

Investing Activities (£)
Purchase of machinery (75,000)
Sale of machinery 10,000
CASH FLOW FROM INVESTING ACTIVITIES (65,000)

Financing Activities (£)
Issue of Shares 80,000
CASH FLOW FROM FINANCING ACTIVITIES 80,000

Total Cash Flow 57,000
Starting Cash 0
Ending Cash 57,000


whereas an indirect cash flow statement will resemble this:

Cash Flow Statement for month ended December 31, 2007

Operating Activities (£)
Net Income 10,000
Less Increase in Inventory (8,000)
Less increase in A/C Receivable (7,000)
Plus increase in A/C Payable 47,000
CASH FLOW FROM OPERATING ACTIVITIES 42,000

Investing Activities (£)
Purchase of machinery (75,000)
Sale of machinery 10,000
CASH FLOW FROM INVESTING ACTIVITIES (65,000)

Financial Activities (£)
Issue of Shares 80,000
CASH FLOW FROM FINANCING ACTIVITIES 80,000

Total Cash Flow 57,000
Starting Cash 0
Ending Cash 57,000

References:

Atrill, P. & McLaney, E. (2006) Accounting and Finance for Non - Specialists (5th Ed.) Essex, Pearson Education Ltd.

Trent, W (2007) Cash Flow Statement - The Indirect Method [Online]
Available from http://financial-education.com/2007/03/26/cash-flow-statement-the-indirect-method/ (Accessed 19th Jan 2008)